What is short selling? What events will lead you to continue your bearish position? Portfolio Manager Ryan Bend provides answers and outlines his strategy for identifying short selling opportunities.
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On identifying short selling opportunities and bear strategy
At a time when the market is defined by its volatility and as uncertainty dominates the economic landscape, many investors are seeking an alternative approach. Portfolio Manager Ryan Bend answers questions about short selling and how it can be used as part of an asset allocation strategy. He also provides an insider’s look at identifying stocks to short and his rationale for a continued bearish outlook.
What is short selling?
Short selling is an investment technique traditionally used by hedge funds and other sophisticated investors. Basically, it’s a way for investors to profit when stock prices go down—the opposite of that old Wall Street axiom, “Buy low, sell high.” As short sellers, what we attempt to do is sell high first, and then buy low. In a short-selling transaction, we borrow shares from a counterparty and then sell those shares in the open market. Ideally, we will then purchase the shares in the open market for a lower price, return them to the counterparty and profit from the difference.
Here's an example. We believe that stock ABC is overvalued at $50 per share. We would borrow, in this case, one share from our counterparty then sell that share in the open market. At this point, we would have $50. If the stock price went down to $30, we could then buy that stock in the open market for $30, return the share to the counterparty and pocket the difference, less any commission costs. It's an alternative strategy and a way to make money when share prices decline.
What are the benefits of including short positions as part of an asset allocation strategy?
For the most part, short selling is inversely correlated to long portfolio holdings. So by allocating a portion of their portfolios to a short selling strategy, investors can pursue additional diversification. This may be particularly effective during periods of market volatility. When the market declines, this is the portion of the portfolio that likely to move upward and benefit investors. Investors nearing retirement or anyone looking to diversify the risk in their portfolios may want to consider utilizing a short position.
How do you identify stocks to short?
There are three primary attributes that our team pursues: stocks that are timely (in terms of shorting opportunity), stocks that are over-valued and those that offer a compelling risk/return. From a timing perspective, we want to identify and be short the stocks where numbers are declining—the company may be missing Wall Street expectations, taking down guidance, having operational issues, losing market share or implementing aggressive accounting to make their performance appear stronger than it actually is.
The second factor is over-valued. Our research team determines the intrinsic value of a stock in order to capture the difference between where the market is pricing the stock and what we believe it is actually worth.
Finally, we're looking for compelling risk/return and this is where the art of short selling comes into play. We use our experience to avoid highly shorted stocks, highly volatile stocks and/or potential acquisition candidates which can cause the stock to go up substantially if it's purchased. The market can be treacherous at times, so when you're investing on the short side there are a number of risk controls and other factors you need to be concerned about and constantly monitor.
What events are contributing to your bearish position?
Right now, it's our view that we're in a derisking, deleveraging environment, which means credit conditions are contracting. This started with Greece and has spread to other peripheral European countries. It's also been exacerbated by fiscal issues here in the United States. So, what we're looking for is the continuing contraction of credit and loss of liquidity in the marketplace. Some of the indicators we monitor include an increase in European debt spreads, fund flows moving out of risk assets, like stocks, and an increase in hedge funds pulling back from risk. From a broad market basis, we're looking at factors such as forecasters and economists adjusting GDP numbers and S&P earnings estimates downward. There are a number of events currently in play that underscore our bearish thesis.
Thank you, Ryan.